Munich Personal RePEc Archive Promise, Trust and Betrayal: Costs of Breaching an Implicit Contract Levy, Daniel and Young, Andrew Bar-Ilan University, Emory University, and RCFEA, Texas Tech University 25 November 2020 Online at https://mpra.ub.uni-muenchen.de/104294/ MPRA Paper No. 104294, posted 03 Dec 2020 13:43 UTC Promise, Trust and Betrayal: Costs of Breaching an Implicit Contract* Daniel Levy Department of Economics, Bar-Ilan University Ramat-Gan 52900, ISRAEL, Department of Economics, Emory University Atlanta GA, 30322, USA, and Rimini Center for Economic Analysis, ITALY [email protected] Andrew T. Young** College of Business Administration Texas Tech University Lubbock, TX 79409, USA [email protected] Last Revision: November 25, 2020 Abstract: We study the cost of breaching an implicit contract in a goods market. Young and Levy (2014) document an implicit contract between the Coca-Cola Company and its consumers. This implicit contract included a promise of constant quality. We offer two types of evidence of the costs of breach. First, we document a case in 1930 when the Coca-Cola Company chose to avoid quality adjustment by incurring a permanently higher marginal cost of production, instead of a one-time increase in the fixed cost. Second, we explore the consequences of the company’s 1985 introduction of “New Coke” to replace the original beverage. Using the Hirschman’s (1970) model of Exit, Voice, and Loyalty, we argue that the public outcry that followed New Coke’s introduction was a response to the implicit contract breach. JEL Codes: E31, K10, L11, L16, L66, M20, M30, N80, N82 Keywords: Invisible Handshake, Implicit Contract, Customer Market, Long-Term Relationship, Cost of Breaching a Contract, Cost of Breaking a Contract, Coca-Cola, New Coke, Exit, Voice, Loyalty, Nickel Coke, Sticky/Rigid Prices, Cost of Price Adjustment, Cost of Quality Adjustment * We are grateful to two anonymous reviewers for constructive comments and suggestions which improved the paper significantly. We thank the seminar participants at the 2017 Italian Law and Economics Association annual conference at the Libera Università Maria Ss. Assunta in Rome, at the 2018 Economic History Association of Israel annual conference at Tel Aviv University in Ramat- Aviv, at the 2015 Israeli History and Law Association annual conference at the Ben-Zvi Institute in Jerusalem, and at Bar-Ilan University in Ramat-Gan, for comments and suggestions. In particular, we thank Joel Mokyr, Alexander Stremitzer, Ansgar Wohlschlegel, Dror Goldberg, Igor Livshits, David Klein, Avichai Snir, Itamar Caspi, and Osnat Peled, for helpful comments and suggestions. We are grateful to Dan Schwarzfuchs and David Geffen for bringing to our attention a 1935 change in the Secret Formula, which we were unaware of. We rotate co-authorship. All errors are ours. ** Corresponding author: [email protected] 1 1. INTRODUCTION Implicit contracts have been hypothesized to play potentially important roles in labor market wage setting (Bailey 1974; Azariadis 1975; Rosen 1985, 1994) and also in price setting for consumer goods (Okun 1980, 1981). However, implicit contracts may also matter in regard to non-price dimensions of market exchanges. In this paper, we offer evidence of the existence of an implicit contract between a firm and its consumers. We argue that this implicit contract included separate “clauses” regarding both price and quality. The firm in question is one of the world’s most recognized and successful producers of a consumer good: the Coca-Cola Company. In general, implicit contracts are difficult to identify empirically. Being implicit, hard data on them are hard to come by.1 For price-setting decisions in goods markets, the most direct evidence available is based on interviews of decision-makers in businesses (e.g., Blinder 1991, 1994; Blinder et al. 1998). Most relevant to the present study, Young and Levy (2014) provide a detailed case study of the Coca-Cola Company, arguing that it had an implicit contract with its consumers that included a constant (nominal) price and also quality. That study focuses on the period (1886 into the 1950s) up through when the constant price was abandoned. In this paper, we explore the more enduring quality clause and the dramatically disastrous breach of it with the introduction of New Coke. On April 23, 1985, New Coke was introduced to the public with much fanfare. Coca- Cola’s market share had been persistently declining, but New Coke was decidedly beating Pepsi in blind taste tests. However, less than three months – and more than 40,000 letters and 400,000 phone calls from angry consumers – later, Coca-Cola Classic (the original “Secret Formula”) was brought back, while New Coke was gradually pulled off the market. We offer two types of empirical evidence of the nature and magnitude of the costs of breach. We build on Young and Levy (2014) who document an implicit contract between the Coca-Cola Company and its consumers. First, we have a good deal of information on how and why the Company arrived at the decision to abandon its fabled Secret Formula in favor of New Coke. We document the costs of research and development and testing involved with New Coke; also the direct losses incurred by Coca-Cola bottlers subsequent to New Coke’s introduction. We use 1 In the context of labor markets, empirical studies have been motivated by a testable restriction across labor-supply and consumption equations (e.g., Beaudry and DiNardo 1995; Ham and Reilly 2002; Kilponen and Santavirta 2010). 2 Hirschman’s (1970) model of exit, voice, and loyalty, as a framework for analyzing the behavior of US consumers in the days that followed New Coke’s introduction. We also document a wealth of “soft” data on costs of breaching implicit contract in terms of goodwill lost. Second, we consider an earlier period when the Coca-Cola Company incurred significant costs to avoid breaching the quality clause. In 1930, the Company faced a government-imposed regulation on the processing of coca leaf extract (the notorious “Merchandise No. 5”). To continue using coca leaves and maintain the Secret Formula, the Company chose to incur a permanently higher marginal cost of production instead of a one-time fixed cost increase. This cost incurred can be viewed as a lower bound of the perceived cost of breaching. The Coca-Cola implicit contract makes for a fascinating case study. It is obviously an extreme case and, as such, will not necessarily generalize to other cases. However, we have access to an exceptional amount of detail regarding how the quality clause was forged, that it was acknowledged in the statements of management, and that management recognized risks involved in breaching it – all of this culminating with decision to introduce New Coke and the rather spectacular aftermath. Understanding this episode can provide important insights into the sort of conditions under which the costs of breaching an implicit contract may be quite large. The paper is organized as follows. In section 2, we discuss the implicit contract theory as it applies to goods markets. A brief summary of the Young and Levy’s (2014) account of the Coca- Cola implicit contract is provided in section 3. In section 4, we document evidence of the permanently higher marginal cost that the company chose to incur in 1930 to avoid a quality change. Then in section 5, we discuss the 1985 episode when the company did choose to breach the quality clause by introducing New Coke. This introduction was costly. There were ex ante costs of R&D and the ex post losses incurred by bottlers. However, New Coke was also accompanied by explicit and often vehement protests by consumers. In section 6, we present a version of Hirschman’s (1970) model of exit, voice, and loyalty as a framework within which to assess and interpret consumer reactions to New Coke. Then in section 7, we document and describe the costs and market responses associated with New Coke, including the explicit consumer reactions. In section 8, we discuss possible reasons for the company’s miscalculation in light of its remarkable customer loyalty. We also consider the New Coke episode in relation to subsequent Coca-Cola product introductions. We conclude in section 9. 3 2. “INVISIBLE HANDSHAKES” An implicit contract is an unwritten, legally non-binding understanding that all parties have incentives to preserve. It will be self-enforcing as long as all parties to it adhere to its terms, continuing to behave as mutually expected. In a seminal studies, Okun (1980, 1981) elaborates on an “invisible handshake” by which sellers and buyers arrive at an understanding of a price that is mutually perceived to be acceptable (or fair) since the marginal costs of search to find a better price exceed the benefits. The stable price discourages buyers from searching because of the implicit commitment of sellers not to raise the price when markets are tight. In return, sellers do not cut the prices when there is insufficient demand. The implicit contract, therefore, helps sellers establish a long-term relationship with buyers, winning their loyalty through stable prices. Another advantage of stable prices is that they make future sales more predictable.2 In the context of goods markets, much of the implicit contract literature is rooted in Okun’s (1981) analysis and emphasizes a stable price as the key component of an implicit contract.3 However, the quality of a good might also be a component of an implicit contract. Implicit understandings of stable quality are consistent with recent episodes of consumers expressing anger and disappointment over quality-adjustments. For example, BBC in 2017 reported on Ferrero SpA changing the ingredients of its popular Nutella spread.